Call and Put Spreads

This is an advanced topic in Option Theory. Please refer to this Options Glossary if you do not understand any of the terms.

A call spread is an option strategy in which a call option is bought, and another less expensive call option is sold. A put spread is an option strategy in which a put option is bought, and another less expensive put option is sold. As the call and put options share similar characteristics, this trade is less risky than an outright purchase, though it also offers less of a reward.

These strategies are useful to pursue if you believe that the underlying price would move in a particular direction, and want to reduce your initial outlay if the prediction is incorrect.

A call spread refers to buying a call on a strike, and selling another call on a higher strike of the same expiry.

A put spread refers to buying a put on a strike, and selling another put on a lower strike of the same expiry.

Most often, the strikes of the spread are on the same side of the underlying (i.e. both higher, or both lower).

An investor buys the 30-35 call spread for $2. At what price must the stock expire at for him to have made money on this trade?

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If the expiration price was below $30, then both of the call would have expired worthless, and the investor would be down by the $2 premium, hence would have lost money.
If the expiration price was below $32 and above $30, then the $30 call would have expired and be worth less than $2, and the $35 call would have expired worthless, and the investor has to pay the $2 premium, hence it would have been a loss.
If the expiration price was below $35 and above $32, then the $30 call would have expired and be worth more than $2, and the $35 call would have expired worthless, and the investor has to pay the $2 premium, hence it would have been a gain.
If the expiration price was above $35, then the $30 call would be worth $5 more than the $30 call, less the $2 premium, hence the investor would have gained \( $5 - $2 = $3 \).

Thus, if the stock expires at $32 and above, the investor would have made money.

Most often, this strategy involves an equal number of options on each strike. Though, sometimes people sell proportionally more of the further strike. These are known as 1 by 2, or even 2 by 3, call/put spreads.

A long call spread is
1. Always long delta
2. Gamma, Vega, Theta depends on the position of the underlying in relation to the strikes.
3. (Typically) Long skew risk
4. Limited profit potential

A long put spread is
1. Always short delta
2. Gamma, Vega, Theta depends on the position of the underlying in relation to the strikes.
3. (Typically) Short skew risk
4. Limited profit potential

Spreads are good to trade when you want to minimize risk, since these options often have complementary greeks. Arbitragers trade spreads with close strikes for edge on the trade, and then manage the position. Position takes like to trade spreads because the short option premium helps to offset the long option cost.

Consider buying call spreads in the following situations:
1. You believe that the underlying is going to move up.
2. You believe that the underlying is going to move up and after which volatility will come off (e.g. a news event)
3. You believe that the underlying is going to move up in a limited range.
4. You believe that the underlying will drop sharply in price, hence sold the underlying. In this case, the call spread will offer you protection against a small move up.

Consider buying put spreads in the following situations:
1. You believe that the underlying is going to move down and after which volatility will come off (e.g. a news event)
2. You believe that the underlying is going to move down in a limited range.
3. You believe that the underling is going to drop down sharply.

Note that if you believe that the underlying is going to drop down sharply, buying put spreads could be dangerous due to the sharp increase in volatility and slope as the future ticks down to your short put. In such a case, you should not be hedging your deltas, but instead let the future settle down.